Mutual funds are one of the most talked-about investment vehicles and tax-efficient vehicles. If one is in the highest income bracket, investing in fixed deposits is the worst thing a person can do because the interest gets added to the taxable income. For example, an investor tends to feel happy if he gets 8 – 9% interest from the FD scheme, but if it is taxable, then the investor's effective post-tax return is 5.6-6.3% in the highest income tax slab. Returns are given in 2 ways: Capital gains or dividends. Both are taxable, and in the following sections, one can learn how these returns are taxed.
A company with surplus cash may give their investors a part of their profits in dividends; one receives them as per the mutual fund units they hold. As per the Union Budget 2020, dividends received by the investors are added to their taxable income and are taxed as per the income tax slab rates. Before this amendment, dividends in investor's hands were tax-free as the companies paid the dividend distribution tax (DDT).
Capital gain is the money someone gets at the maturity period or exiting the mutual funds due to the appreciation of the mutual fund's unit value. Taxation on capital gains depends on two things, the Holding period and the type of mutual fund.
The holding period is the duration between the buying and selling off of the mutual fund unit. There are three types of mutual funds, which are as following:
- Equity fund: Equity funds are those mutual funds whose portfolio's equity exposure exceeds 65%
- Debt Fund: Debt funds are those mutual funds whose portfolio's debt exposure is more than 65%.
- Hybrid Fund: If the equity exposure is greater than 65% then, taxes will be applied similar to that of equity funds, and if not, then taxation will be the same as debt funds
The following table gives the taxation as per the classification:
|Mutual Fund Type||Holding period||Taxation|
|Equity Funds||<12 months||15% + cess + surcharge|
|Equity Funds||>12 months||Up to ₹ 1 lakh/year is tax-exempt, but any gains above ₹ 1 lakh are taxed at 10% + cess + surcharge|
|Debt Funds||<36 months||Taxed as per the investor's income tax slab rate|
|Debt Funds||>36 months||20% + cess + surcharge|
In the case of Systematic Investment plans (SIP), where investors invest a small amount periodically. One purchases a certain number of mutual fund units through every installment; if these equity fund units are sold within a year, it will be subjected to short-term capital gains, which is 15% irrespective of the income tax slab along with the cess and surcharge on it. If it is sold after 12 months, a long-term capital gain is realized and taxed accordingly.
Other than the tax on dividends and capital gains, another tax is called the Securities Transaction Tax (STT). The Ministry of Finance levies an STT of 0.001% when one decides to sell or buy mutual fund units of an equity fund or a hybrid equity-oriented fund. However, there is not any STT on the sale of debt fund units.
The longer you hold on to your mutual fund units, the more tax-efficient they become. The tax on long-term capital gains is comparatively lower than the tax on short-term gains.